MLPs Let Renewables Capitalize in New York not Washington

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April 25, 2013

James Valvo

It’s time to treat renewable energy providers just like everyone else. In many ways, the playing field is dramatically tilted in their favor, with myriad tax credits, grant programs, loan guarantees and purchase mandates. However, federal policy still excludes renewables, coal-fired electricity production and nuclear from an important business structure from which other forms of energy have benefited. Congress should expand access to this business structure and put renewables on a level playing field with other forms of energy. At the same time, they should end the ridiculous catalogue of provisions that attempt to pick winners and losers by subsidizing renewables to the hilt. It’s time to let the market work and allow broader access to the private equity markets: Congress should allow master limited partnerships to include income from renewable, coal-fired electricity and nuclear investments in their “qualifying income.”

Master limited partnerships (MLPs) are a type of publically traded partnership, meaning they are organized as partnerships but traded like corporate stocks. MLPs have general partners who run the day-to-day operations and limited partners who provide capital but take no active role in running the business. MLPs are required to return the vast majority of their earnings (plus tax deductions and credits) back to the limited partners (known as unitholders) on a regular basis. MLPs don’t pay partnership-level tax and thus earnings are only subject to a single level of taxation. This is an attractive business structure and the growth in MLPs over the past decade has been substantial. One limitation on MLPs is that 90 percent of their income must come from eligible sources. Those sources include: exploration, development, production, processing and transportation of natural resources, typically oil, natural gas, coal and other depletable minerals. It currently does not include renewable sources, coal-fired electricity generation or nuclear.

The main reason to expand the energy sources that are eligible for the MLP tax structure is that it will shift those industries’ capital procurement away from Washington and toward New York. For far too long renewable energy has clung to the infant-industry argument and remained hooked on D.C. to subsidize their start-up and operating capital. The Department of Energy’s now-embarrassed loan guarantee program dramatically lowered the cost of start-up capital for many renewable companies and nuclear investments. On the operating-capital side, the poster child for perpetual infancy is the wind industry, which has been dependent on the production tax credit for more than 20 years. Their trade association, AWEA, launches major lobbying campaigns anytime the PTC is set to expire. Broadening MLP eligibility while simultaneously (and this is the critical component) ending the production tax credit has the potential to turn renewables’ attention to the same place other fledgling sectors get their capital: the equity markets.

Another important reason that renewables should have access to MLPs is because this structure avoids the double taxation of corporate earnings. The shift from C corps to pass-through entities is a well-documented trend. There are multiple inputs to this business decision but treating business earnings correctly by only taxing them once is an attractive feature of the partnership code. There’s no reason renewables’ earnings shouldn’t receive that proper treatment as well.

It’s not all upside if Congress lets MLPs count renewable investments toward their qualifying income. Because of the need to consistently distribute cash to limited partners, stable revenue streams are an essential component of functioning MLPs. The predictable revenue streams from conventional fuel sources (think pipelines and natural gas processing) are the reason they’re attractive to MLP investors. This year more than 80% of MLPs are invested in the energy and natural resources sector. This is a product of the qualifying income requirements and the revenue stream stability.

This necessary stability creates a challenge for many renewable energy sources because their revenue streams are often tied to government purchase mandates (state-based RPSs, EPA’s blending mandates, etc.) and not to consumer demand. Expanding MLP access to renewables could have the adverse consequence of increasing the number of stakeholders lobbying federal and state lawmakers to keep renewable purchase mandates in place. Just as the renewable industries should move from Washington to New York for their capital needs, they should also transition their products’ revenue streams away from government support. MLPs have the potential to increase that government dependency if limited partners see an avenue to quick and easy cash distributions procured through rent-seeking purchase mandates. Supporters of economic freedom must work overtime to eliminate those mandates. The uncertainty and political volatility that surrounds renewables’ economic viability is an obstacle for investors to embrace MLPs. However, this is a decision for individual investors to make based on the merits of a particular project.

One caveat: Congress must maintain the existing passive loss rules as they apply to MLPs in order to ensure renewables do not become an attractive tax shelter that would lead to an unhealthy investment bubble. In The End of Energy, Michael Graetz detailed the problems California experienced during the 1980s when its wind tax credits became a magnet for tax abuse. Graetz illustrated that due a combination of federal and state credits, an investor could produce tax savings “five times his investment, whether the turbines actually produced any electricity or not.” This “gold plating” led to a large boom and bust as investors rushed to take advantage of the shelter and then retreated once Congress got wise to the trick. As Graetz put it, the tax fix “let all the air out of the California wind rush.” Ensuring that unitholders cannot use passive renewable MLP losses to offset their active income is an important protection to attract the right kind of investment.

On balance, expanding the definition of MLP qualifying income to include renewables (as well as coal-fired electricity generation and nuclear) is a good idea. We must also end the PTC and other D.C. subsidies for these energy sources. This will give renewables a chance to grow and join other sectors securing their capital from investors who will push them to be more efficient and stable contributors to the country’s energy needs.

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